《中国金融市场 Chinese Financial Markets》补充阅读文献：development of rmb market in hk（imf-2013）

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o 2013 International Monetary Fund WP/3/268 IMF Working Paper Asia and Pacific Department Development of the renminbi market in Hong Kong Sar Assessing Onshore-Offshore Market Integratio Prepared by r. sean Craig, Changchun Hua, Philip ng, and Raymond Yuen Authorized for distribution by Steven Barnett December 2013 This Working Paper should not be reported as representing the views of the mme. The views expressed in this Working Paper are those of the author(s)and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s)and are published to elicit comments and to further debate Abstract Offshore use of the renminbi expanded rapidly in Hong Kong SAR as China sought to develop an international role for its currency while maintaining capital controls. This prompts two questions addressed in this paper: How far advanced is renminbi nternationalization? And, what role does Chinese capital account liberalization play? The first is addressed by testing the extent of integration of offshore and onshore markets for the renminbi using a Threshold Autoregression(TAr)model and finds that there are substantial unexploited arbitrage opportunities. A VAR model is used to indentify factors contributing to this limited market integration and finds that capital controls and shifts in global market sentiment explain much of the divergence in onshore and offshore renminbi exchange rates. To address the second question, the paper shows how capital account measures have been used to promote offshore use of the renminbi more actively in the wake of the global financial crisis, but that this was done asymmetrically with controls on inflows eased to a greater extent than on outflows. It concludes that a more balanced liberalization process will sustain progress in renminbi internationalization JEL Classification Numbers: E61 F33 F36.011019 Keywords:capital controls, offshore financial markets Authors'e-mailAddress:rcraig@imforgchangchunhua(@nomura.com phtng(@hkma. gov hk; rsyyuen @hkma. gov.hk

© 2013 International Monetary Fund WP/13/268 IMF Working Paper Asia and Pacific Department Development of the Renminbi market in Hong Kong SAR: Assessing Onshore-Offshore Market Integration Prepared by R. Sean Craig, Changchun Hua, Philip Ng, and Raymond Yuen Authorized for distribution by Steven Barnett December 2013 Abstract Offshore use of the renminbi expanded rapidly in Hong Kong SAR as China sought to develop an international role for its currency while maintaining capital controls. This prompts two questions addressed in this paper: How far advanced is renminbi internationalization? And, what role does Chinese capital account liberalization play? The first is addressed by testing the extent of integration of offshore and onshore markets for the renminbi using a Threshold Autoregression (TAR) model and finds that there are substantial unexploited arbitrage opportunities. A VAR model is used to indentify factors contributing to this limited market integration and finds that capital controls and shifts in global market sentiment explain much of the divergence in onshore and offshore renminbi exchange rates. To address the second question, the paper shows how capital account measures have been used to promote offshore use of the renminbi more actively in the wake of the global financial crisis, but that this was done asymmetrically with controls on inflows eased to a greater extent than on outflows. It concludes that a more balanced liberalization process will sustain progress in renminbi internationalization. JEL Classification Numbers: E61, F33, F36, O11, O19 Keywords: capital controls, offshore financial markets Authors’ E-Mail Address: rcraig@imf.org; changchun.hua@nomura.com; phtng@hkma.gov.hk; rsyyuen@hkma.gov.hk This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

2 Contents Page I. Introduction ............................................................................................................................3 II. Development of the Offshore Renminbi Market .......................................................................3 III. Assessing Renminbi Internationalization by Analyzing Arbitrage .....................................5 A. Defining Progress in Renminbi Internationalization ......................................................5 B. Estimating Integration of Onshore and Offshore Renminbi Markets .............................6 C. Arbitrage Between Onshore and Offshore Markets and the Role of Capital Controls ...7 D. Sources of Divergence of Onshore and Offshore Renminbi Exchange Rates ................7 IV. Role of Capital Account Liberalization in Renminbi Internationalization ..........................9 A. Evolution of China’s Capital Account Liberalization Strategy ......................................9 B. The Impact of Liberalization Measures on Mainland Capital Flows ............................11 C. Hong Kong SAR's Role in Mainland Capital Account Opening ..................................12 D. Renminbi Internationalization and the Offshore Renminbi Liquidity Pool ..................14 V. Conclusions .........................................................................................................................15 References ............................................................................................................................... 23 Figures 1. Renminbi Cross-Border Trade Settlement .......................................................................... 3 2. "Dim-Sum" Bonds Outstanding .......................................................................................... 4 3. Renminbi Loans in Hong Kong SAR ................................................................................. 4 4. Renminbi Liquidity Pool in Hong SAR .............................................................................. 5 5. CNY and CNH Spot Exchange Rate Differentials ............................................................. 6 6. Correlation of Basis and Renminbi Deposits and CDs in Hong Kong SAR ...................... 8 7. Correlation of Basis and Renminbi Risk Reversal ............................................................. 8 8. Mainland China's Private Capital Flows ........................................................................... 12 9. Mainland China's Foreign Direct Investments by Destination ......................................... 13 10. Mainland China's Overseas Direct Investment by Destination ........................................ 13 11. Average Asset Allocation to Hong Kong SAR by Equity-Oriented QDII Funds ............ 13 12. Mainland China's External Positions vis-à-vis Hong Kong SAR Banks .......................... 13 13. Mainland China's Renminbi FDI and ODI, Monthly Flows ............................................. 14 14. Mainland China's Renminbi FDI and ODI Percent of Total ............................................ 14 15. Cross-Border Renminbi Trade Settlement ........................................................................ 14 Tables 1. TAR Model Estimation Results .......................................................................................... 6 2. Key Mainland China Capital Account Liberalization Measures ...................................... 10 3. Measures to Support RMB Market Development in Hong Kong SAR ............................ 11 Technical Annex ..................................................................................................................... 17

. NTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross b transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, issuance and lending in Hong Kong SAR. This growth leveled off in 201 1 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section Ill assesses progress in enminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression(TAR) model is applied to daily data to test whether differential between the offshore exchange rate(the CNh)and the onshore exchange rate (the CNy) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. a VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR Controls on capita inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization I. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragil ities of the dollar-based international financial system Figure 1. Renminbi Cross-Border Trade Settlement Promotion of an international role of the renminbi (RMB bn) initially focused on trade settlement. This started 1000 with a pilot scheme for cross-border trade settlement 900 Service trade(left axis) Goods trade(left axis) in renminbi in 2009 that had expanded to all Share of goods mainland exporters and importers by 2012. This 600F trade settled in reflected the practical objective of allowing more goods trad Chinese corporates to conduct cross-border trade their own currency to eliminate the currency risk The effort met with considerable success as the share of mainland goods trade denominated in renminbi 2012 2013 3

3 I. INTRODUCTION The development of an international role for the renminbi is tied to Chinese capital account liberalization. The selective easing of mainland capital controls expanded the range of cross border transactions denominated in renminbi and led to rapid growth in offshore renminbi deposits, bond issuance and lending in Hong Kong SAR. This growth leveled off in 2011 and has recently resumed at a more modest pace. These developments raise several questions. First, how far advanced is renminbi internationalization? This question can be addressed by assessing how effectively the offshore currency is functioning as a substitute for the onshore currency. Second, how has capital account liberalization supported the offshore use of the renminbi? And, third, how can this progress be sustained? The next section examines the expansion in the offshore role of the renminbi, highlighting the uneven process across different uses of the offshore currency. Section III assesses progress in renminbi internationalization by estimating the integration of offshore and onshore renminbi markets. Specifically, a Threshold Autoregression (TAR) model is applied to daily data to test whether differential between the offshore exchange rate (the CNH) and the onshore exchange rate (the CNY) involves unexploited arbitrage opportunities and finds that this is the case. This likely reflects the limits on arbitrage from capital controls together with other factors. A VAR model is applied to monthly data to identify these factors and finds that shifts in global market sentiment plays a key role along with capital controls. Section IV examines how Chinese liberalization measures have promoted offshore use of the renminbi in Hong Kong SAR. Controls on capital inflows have been eased more than on outflows, suggesting that, going forward, more balanced liberalization measures would help sustain progress in renminbi internationalization. II. DEVELOPMENT OF THE OFFSHORE RENMINBI MARKET China is seeking to promote the international use of its currency while maintaining capital controls through the development of offshore markets for the renminbi. The offshore renminbi was established in 2003, with the creation of an offshore settlement infrastructure and personal renminbi banking services in Hong Kong SAR. Efforts to develop offshore renminbi financial products and services accelerated in 2009 as the global financial crisis exposed the fragilities of the dollar-based international financial system. Promotion of an international role of the renminbi initially focused on trade settlement. This started with a pilot scheme for cross-border trade settlement in renminbi in 2009 that had expanded to all mainland exporters and importers by 2012. This reflected the practical objective of allowing more Chinese corporates to conduct cross-border trade in their own currency to eliminate the currency risk. The effort met with considerable success as the share of mainland goods trade denominated in renminbi Figure 1. Renminbi Cross-Border Trade Settlement 0 2 4 6 8 10 12 14 16 18 0 100 200 300 400 500 600 700 800 900 1,000 2010 2011 2012 2013 Service trade (left axis) Goods trade (left axis) (RMB bn) (%) Share of goods trade settled in RMB in total goods trade Source: People’s Bank of China

reached 1l percent. Adding trade in services to goods, the quarterly volume exceeds RMB 1 trillion in Q1 2013 for the first time( Figure 1). This strong progress in renminbi trade settlement was not matched on the financing side Most firms reportedly continued to denominate offshore treasury operations in dollars. This is attributed by market participants to the fact that offshore currency markets are more developed than offshore rates markets. There is reportedly good liquidity in renminbi spot, forwards and swap markets but renminbi interest rate swap and repo markets are still lacking This leads corporate treasury managers to continue to operate in dollars where these markets are well developed, deep and liquid, which allow more effective hedging of interest rate and other risks. There has been substantial growth in offshore renminbi debt instruments, but secondary market liquidity is low partly owing to the lack of offshore money markets. The introduction of an offshore renminbi interest rate fixing in June 2013(that is, a CNH HIBOR fixing)should help by anchoring pricing in offshore interest rate swap and repo markets The stock of offshore renminbi financial assets expanded steadily with the supply of Dim Sum"bonds reaching RMB 267 billion by March 2013(Figure 2 ) Renminbi bank loans in Hong Kong Sar also expanded, reaching RMB 89 billion by March-2013(Figure 3). Both benefitted from liberalization measures that opened channels for offshore renminbi to flow back to the Mainland through renminbi denominated fdi and into mainland interbank bond equity and fixed income markets, which allowed these onshore investments to be funded offshore. Finally, a wide range of specialized offshore renminbi products have been created, including equity reit (listed in April 2011), renminbi Exchange-Traded Funds, insurance products, derivatives(offshore deliverable renminbi futures and options)and commodities (e.g, Gold ETFS, listed in February 2012) Figure 2."Dim-Sum"Bonds Outstanding Figure 3. Renminbi Loans in Hong Kong SAR (RMB bn) (RMB bn) March o/s: RMB aOutstanding RMB loans in Hong Kong SAR 200 200 100 2010 Source: Hong Kong Monetary Authority(HKMA Growth in renminbi bank deposits, including certificates of deposits, has been less steady They rose from 2 percent to 1 l percent of total deposits in Hong Kong Sar in less than two years; but, then, peaked at RMB 700 billion in November 201 1 and contracted. Only recently have they started to expand again, reaching of rMb 812 billion in March 2013( Figure 4) This temporary stagnation in renminbi deposits was associated with an increase in the I This working paper uses information up to April 2013

4 reached 11 percent. Adding trade in services to goods, the quarterly volume exceeds RMB 1 trillion in Q1 2013 for the first time (Figure 1).1 This strong progress in renminbi trade settlement was not matched on the financing side. Most firms reportedly continued to denominate offshore treasury operations in dollars. This is attributed by market participants to the fact that offshore currency markets are more developed than offshore rates markets. There is reportedly good liquidity in renminbi spot, forwards and swap markets but renminbi interest rate swap and repo markets are still lacking. This leads corporate treasury managers to continue to operate in dollars where these markets are well developed, deep and liquid, which allow more effective hedging of interest rate and other risks. There has been substantial growth in offshore renminbi debt instruments, but secondary market liquidity is low partly owing to the lack of offshore money markets. The introduction of an offshore renminbi interest rate fixing in June 2013 (that is, a CNH HIBOR fixing) should help by anchoring pricing in offshore interest rate swap and repo markets. The stock of offshore renminbi financial assets expanded steadily with the supply of “DimSum” bonds reaching RMB 267 billion by March 2013 (Figure 2). Renminbi bank loans in Hong Kong SAR also expanded, reaching RMB 89 billion by March-2013 (Figure 3). Both benefitted from liberalization measures that opened channels for offshore renminbi to flow back to the Mainland through renminbi denominated FDI and into mainland interbank bond, equity and fixed income markets, which allowed these onshore investments to be funded offshore. Finally, a wide range of specialized offshore renminbi products have been created, including equity REIT (listed in April 2011), renminbi Exchange-Traded Funds, insurance products, derivatives (offshore deliverable renminbi futures and options) and commodities (e.g., Gold ETFs, listed in February 2012). Source: Hong Kong Monetary Authority (HKMA) Figure 3. Renminbi Loans in Hong Kong SAR 0 10 20 30 40 50 60 70 80 90 2010 2011 2012 Outstanding RMB loans in Hong Kong SAR (RMB bn) Growth in renminbi bank deposits, including certificates of deposits, has been less steady. They rose from 2 percent to 11 percent of total deposits in Hong Kong SAR in less than two years; but, then, peaked at RMB 700 billion in November 2011 and contracted. Only recently have they started to expand again, reaching of RMB 812 billion in March 2013 (Figure 4). This temporary stagnation in renminbi deposits was associated with an increase in the 1 This working paper uses information up to April 2013. Figure 2. “Dim-Sum” Bonds Outstanding 0 50 100 150 200 250 300 0 50 100 150 200 250 300 2007 2008 2009 2010 2011 2012 2013 Bonds/Notes March o/s: RMB 267 bn (RMB bn) (RMB bn)

perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding These deposits represent a pool of renminbi liquidity in Hong Kong Sar that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial Figure 4. Renminbi Liquidity Pool in Hong Kong SAR products despite its contraction and, thus, did (RMB bn) not constrain their growth. But, going 000 Share of renminbi deposits(incl. CDs) in HK forward, offshore renminbi liquidity will need to expand in parallel with assets to Corporate customers 600■ Personal ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi 20 into offshore renminbi deposits in response o LImIT to market incentives for arbitrage. However, Jul Jan Jul Jan the scale of these flows and hence the 0092010 potential for arbitrage, are constrained by Source: HKMA capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization I. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining progress in renminbi internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them This will be the case when the difference between the cny and cnh exchange rates with the dollar(the basis")is small enough to remain in a"no-arbitrage band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this 9 Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face ignificant basis risk the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi They either try to use the cny itself--which is difficult due to capital controls- or the dollar where risks can be better hedge

5 perceived risk of using the offshore currency, which led offshore investors to reduce renminbi holding. These deposits represent a pool of renminbi liquidity in Hong Kong SAR that can be redeployed to support the expansion of offshore financial markets and products. The pool remained significantly larger than the stock of renminbi financial products despite its contraction and, thus, did not constrain their growth. But, going forward, offshore renminbi liquidity will need to expand in parallel with assets to ensure progress in renminbi internationalization. In theory, the pool will be replenished by flows of onshore renminbi into offshore renminbi deposits in response to market incentives for arbitrage. However, the scale of these flows and, hence, the potential for arbitrage, are constrained by capital controls. This suggests that an analysis of the effectiveness of arbitrage can shed light on how these controls are limiting progress in renminbi internationalization. III. ASSESSING RENMINBI INTERNATIONALIZATION BY ANALYZING ARBITRAGE A. Defining Progress in Renminbi Internationalization Progress in internationalizing the renminbi can be evaluated based on how well the offshore market functions as a substitute for the onshore market. To tell whether the two markets are integrated, we assess whether there are no unexploited arbitrage opportunities between them. This will be the case when the difference between the CNY and CNH exchange rates with the dollar (the “basis”) is small enough to remain in a “no-arbitrage” band, within which arbitrage is not profitable owing to transaction costs such as the bid-ask spread. A metric of the integration of the offshore and onshore markets can be derived by estimating a no-arbitrage band and then assessing the extent that the CNY-CNH basis stays within this band. Estimation shows that the no-arbitrage band is quite wide. Moreover, the basis is outside the band for extended periods, indicating that the offshore renminbi is an imperfect substitute for the onshore renminbi. The differential is often large, indicating that investors and firms face significant “basis risk:” the risk that by using CNH in place of CNY could incur significant losses owing to volatility in the basis. An increase in the perceived basis risk makes investors and firms more reluctant to use CNH as a substitute for the CNY, holding back development of an international role for the renminbi. They either try to use the CNY itself—which is difficult due to capital controls—or the dollar where risks can be better hedged. Figure 4. Renminbi Liquidity Pool in Hong Kong SAR 0 2 4 6 8 10 12 14 0 100 200 300 400 500 600 700 800 900 1000 Jul Jan Jul Jan Jul Jan Jul Jan (RMB bn) Certificate of deposits Corporate customers Personal customers 2009 2010 2011 2012 2009 2010 2011 2012 2013 (%) Share of renminbi deposits (incl. CDs) in HK total deposits (right scale) Source: HKMA

B. Estimating integration of onshore and offshore renminbi markets This research differs from other papers in the literature in that it assesses the integration of renminbi offshore and onshore markets in that it applies a Threshold Autoregession model (TAR)model to estimate the no-arbitrage band and checks how much the basis is outside the band. Other studies, for example HKMA (2012); Ding, Tse, and williams(2012); Maziad and Kang(2012); and Wu and Pei(2012), assess renminbi onshore/offshore market linkages using Granger causality test or GARCH models. They focus on price discovery directions that within the band the basis follows a random walk as transaction costs make arbitrage and volatility spillovers between the two markets. Estimation in this paper exploits the fact unprofitable. In contrast, outside the band it follows an autoregressive process as arbitrage is profitable and moves the basis back towards the band. The estimated parameters of the autoregressive process indicate the speed of this convergence back to the band and will depend on the volume of the arbitraging capital flows between onshore and offshore markets possible under existing capital controls The data are differentials between the daily Cny and CNh(onshore and Figure 5. CNY and CNH Spot Exchange Rate Differentials offshore)dollar spot exchange rates The estimated width of the band - Spot exchange rate difference(CNY-CNH) 253 pips, roughly one quarter of a percentage point(Figure 5). Statistical tests confirm that the basis follows random walk within the band and an 500 autoregressive process outside it (Annex Table 3). The data start in nber 2010 when CNH first began to trade actively. Despite over Sources: Bloomberg LP, and IMF staff estimations. 600 observations the sample is 1 Band is estimated with the TAR model on the sample of 1 September 2010-31 January 2013. Around 56 percent of observations are within the band. relatively short and the estimated width of the band could be different for different sample periods, either for statistical easons or because transaction costs can change with institutional market reforms. An example of how differences in market infrastructure can lead to different band widths comes rom applying the TAr model to other onshore-off-shore exchange rate Table 1. tar model estimation results s. as is done for the differentials ependent Variable: CNY-CNH Results between the onshore three-month CNY weaker than CNH (pos basis) L5 percent of time forward rate and (i) the offshore Autoregressive coefficient three-month nondeliverable forward Implied "half life 25 days rate(NDF)and (ii) three-month CNY-CNH basis trades within band 56 percent of time deliverable forward rate in hong CNY stronger than CNH(neg basis) 29 percent of time Kong SAr, respectively, as shown in the annex Implied"half life Note: *** indicates significance at the l percent level. The technical ar The estimation results find limited provides full estimation results

6 B. Estimating Integration of Onshore and Offshore Renminbi Markets This research differs from other papers in the literature in that it assesses the integration of renminbi offshore and onshore markets in that it applies a Threshold Autoregession model (TAR) model to estimate the no-arbitrage band and checks how much the basis is outside the band. Other studies, for example HKMA (2012); Ding, Tse, and Williams (2012); Maziad and Kang (2012); and Wu and Pei (2012), assess renminbi onshore/offshore market linkages using Granger causality test or GARCH models. They focus on price discovery directions and volatility spillovers between the two markets. Estimation in this paper exploits the fact that within the band the basis follows a random walk as transaction costs make arbitrage unprofitable. In contrast, outside the band it follows an autoregressive process as arbitrage is profitable and moves the basis back towards the band. The estimated parameters of the autoregressive process indicate the speed of this convergence back to the band and will depend on the volume of the arbitraging capital flows between onshore and offshore markets possible under existing capital controls. The data are differentials between the daily CNY and CNH (onshore and offshore) dollar spot exchange rates. The estimated width of the band is 253 pips, roughly one quarter of a percentage point (Figure 5). Statistical tests confirm that the basis follows a random walk within the band and an autoregressive process outside it (Annex Table 3). The data start in September 2010 when CNH first began to trade actively. Despite over 600 observations, the sample is relatively short and the estimated width of the band could be different for different sample periods, either for statistical reasons or because transaction costs can change with institutional market reforms. An example of how differences in market infrastructure can lead to different band widths comes from applying the TAR model to other onshore-off-shore exchange rate pairs; as is done for the differentials between the onshore three-month forward rate and (i) the offshore three-month nondeliverable forward rate (NDF) and (ii) three-month deliverable forward rate in Hong Kong SAR, respectively, as shown in the Annex. The estimation results find limited -1500 -1000 -500 0 500 1000 1500 2000 -1500 -1000 -500 0 500 1000 1500 2000 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Spot exchange rate difference (CNY-CNH) Band: (-32, 221) 1/ Sources: Bloomberg L.P.; and IMF staff estimations. 1/ Band is estimated with the TAR model on the sample of 1 September 2010‒31 January 2013. Around 56 percent of observations are within the band. Figure 5. CNY and CNH Spot Exchange Rate Differentials Dependent Variable: CNY-CNH Results CNY weaker than CNH (pos. basis) 15 percent of time Autoregressive coefficient 0.97*** Implied "half life" 25 days CNY-CNH basis trades within band 56 percent of time CNY stronger than CNH (neg. basis) 29 percent of time Autoregressive coefficient 0.88*** Implied "half life" 6 days Table 1. TAR Model Estimation Results Note: *** indicates significance at the 1 percent level. The technical annex provides full estimation results

integration between onshore and offshore markets they show that the basis trade within the no-arbitrage band only 56 percent of the time(Table 1). This fact, together with the large, absolute positive and negative values for the basis(peaking at 1, 795 and-1, 235 pips espectively), suggest users of offshore renminbi face relatively high basis risk, which serves to discourage them from using the CNh as a substitute for CNY. This awareness of basis risk may have increased with the sharp rise in the volatility in the basis in the second half of 2011, which may help explain the temporary stalling of CNH deposit growth as users became more cautious in holding CNH in place of CNY(Figure 4) C. Arbitrage between Onshore and offshore markets and the role of capital controls The estimation results confirm that arbitrage works to steadily narrow the basis when shocks air processes followed by the basis when outside the band. The coefficient on move it outside the no-arbitrage band. This is reflected in the highly significant coefficient estimates are fairly close to one, indicating that th e convergence process is relatively slow and may reflect limits on the scale of arbitraging capital flows owing to capital controls The estimation results reveal an asymmetry in the speed with which capital inflow and outflow work to narrow divergences in the offshore and onshore exchange rates. Arbitrage is much slower when the CNh is stronger than the Cny than when it is weaker, specifically When CNH trades at a premium to CNY, arbitrage takes an average of 25 days to close half the gap back to the band (the"half life")(Table 1). Capital outflows from the mainland are needed for this arbitrage, and work to increases the supply of offshore renminbi liquidity. This was the case in the November 2010-May 2011 episode When CNh trades at a discount to CNY, arbitrage takes an average of 6 days to close half the gap back to the band. This involves capital inflows to the mainland, reducing the supply of offshore renminbi liquidity. This was the case in September 201 1-October 2012 The faster rate of convergence in the latter case-when CNh trades at a discount to CNY- implies that capital controls are less restrictive with respect to arbitraging capital inflows to the mainland than outflows from the mainland. This difference may reflect the fact that recent liberalization measures have focused more on easing constraints on inflows than outflows(see section Iv below), such as the opening of channels for renminbi denominated FDI and QFll that can be used to bring offshore renminbi funds onshore D. Sources of divergence of onshore and offshore renminbi exchange rates The movement in the basis outside the no-arbitrage band will be driven by a number of factors that, along with capital controls, contribute to limited integration of onshore and offshore markets. The literature points to a range of potential factors, including market expectations for the renminbi, market risk sentiment, capital controls and offshore renminbi liquidity. For example, arbitraging capital flows would lead to changes in offshore renminbi liquidity that would be negatively correlated with the basis. This appears to be the case, with

7 integration between onshore and offshore markets. They show that the basis trade within the no-arbitrage band only 56 percent of the time (Table 1). This fact, together with the large, absolute positive and negative values for the basis (peaking at 1,795 and -1,235 pips, respectively), suggest users of offshore renminbi face relatively high basis risk, which serves to discourage them from using the CNH as a substitute for CNY. This awareness of basis risk may have increased with the sharp rise in the volatility in the basis in the second half of 2011, which may help explain the temporary stalling of CNH deposit growth as users became more cautious in holding CNH in place of CNY (Figure 4). C. Arbitrage between Onshore and Offshore Markets and the Role of Capital Controls The estimation results confirm that arbitrage works to steadily narrow the basis when shocks move it outside the no-arbitrage band. This is reflected in the highly significant coefficient on the autoregressive processes followed by the basis when outside the band. The coefficient estimates are fairly close to one, indicating that the convergence process is relatively slow and may reflect limits on the scale of arbitraging capital flows owing to capital controls. The estimation results reveal an asymmetry in the speed with which capital inflow and outflow work to narrow divergences in the offshore and onshore exchange rates. Arbitrage is much slower when the CNH is stronger than the CNY than when it is weaker, specifically:  When CNH trades at a premium to CNY, arbitrage takes an average of 25 days to close half the gap back to the band (the “half life”) (Table 1). Capital outflows from the mainland are needed for this arbitrage, and work to increases the supply of offshore renminbi liquidity. This was the case in the November 2010-May 2011 episode.  When CNH trades at a discount to CNY, arbitrage takes an average of 6 days to close half the gap back to the band. This involves capital inflows to the mainland, reducing the supply of offshore renminbi liquidity. This was the case in September 2011-October 2012 period. The faster rate of convergence in the latter case—when CNH trades at a discount to CNY— implies that capital controls are less restrictive with respect to arbitraging capital inflows to the mainland than outflows from the mainland. This difference may reflect the fact that recent liberalization measures have focused more on easing constraints on inflows than outflows (see section IV below), such as the opening of channels for renminbi denominated FDI and QFII that can be used to bring offshore renminbi funds onshore. D. Sources of Divergence of Onshore and Offshore Renminbi Exchange Rates The movement in the basis outside the no-arbitrage band will be driven by a number of factors that, along with capital controls, contribute to limited integration of onshore and offshore markets. The literature points to a range of potential factors, including market expectations for the renminbi, market risk sentiment, capital controls and offshore renminbi liquidity. For example, arbitraging capital flows would lead to changes in offshore renminbi liquidity that would be negatively correlated with the basis. This appears to be the case, with

renminbi deposits and CDs in Hong Kong SaR surging when the Cnh trades at a premium to the CNY, and vice-versa(Figure 6). The influence of shifts in investor sentiment can also be seen in the correlation between the basis and the renminbi risk reversal- which is an index market sentiment(Figures 7) Figure 6. Correlation of Basis and Renminbi Figure 7. Correlation of Basis and Renminbi Risk Deposits and CDs in Hong Kong SAR Reversal RMB bn 1200 1000 arbitrage band arbitrage bi 642 400 600 Renminbi deposits and CDs in Hong Kong SAR Renminbi risk reversal index(3m)l/ CNY-CNH (left scale) CNY-CNH (left scale Sources: Bloomberg LP and IMF staff estimation. Sources: Bloomberg LP, and IMF staff estimation. 1/ Represents market view of the most likely direction of the spot movement over the next three months To confirm that the influence of these variables( Figures 6 and 7)on the basis is robust we estimate a VaR model to test their statistical significance and control for a range of other variables. The dependent variables in the VAR is the onshore-offshore renminbi differential with the following explanatory variables found to have a statistically significant impact, as reflected in VAR impulse-response functions(see the Annex for technical details) the change in renminbi liquidity as measured by deposits and CDs in Hong Kong SAr (Figure 6) the three-month renminbi risk reversal index(Figure 7) a dummy variable for the opening of new channels for renminbi cross-border flows (see Annex for detailed definitions) a dummy for when the quota is hit on the size of the aggregate net position that Hon Kong Sar banks can square with the clearing bank at onshore rates for trade-related renminbi payments The VaR results confirm that the basis is affected by changes in offshore renminbi liquidity This is the case even when controlling for the endogenity that results from the fact that the arbitrage narrowing the basis also affects offshore liquidity. The results also show that shift 2 The reversal index is defined as the implied volatility for call options minus the implied volatility for put options on the base currency with the same delta. It can be interpreted as the market view of the most likely direction of the spot movement over the next maturity date 8

8 renminbi deposits and CDs in Hong Kong SAR surging when the CNH trades at a premium to the CNY, and vice-versa (Figure 6). The influence of shifts in investor sentiment can also be seen in the correlation between the basis and the renminbi risk reversal,2 which is an index market sentiment (Figures 7). Figure 6. Correlation of Basis and Renminbi Deposits and CDs in Hong Kong SAR Figure 7. Correlation of Basis and Renminbi Risk Reversal -600 -400 -200 0 200 400 600 800 1000 1200 -40 -20 0 20 40 60 80 10/8 10/10 10/12 11/2 11/4 11/6 11/8 11/10 11/12 12/2 12/4 12/6 12/8 12/10 12/12 Renminbi deposits and CDs in Hong Kong SAR CNY-CNH (left scale) RMB bn pips Shaded area: outside of estimated noarbitrage band -600 -400 -200 0 200 400 600 800 1000 1200 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 10/8 10/10 10/12 11/2 11/4 11/6 11/8 11/10 11/12 12/2 12/4 12/6 12/8 12/10 12/12 Renminbi risk reversal index (3m) 1/ CNY-CNH (left scale) % pips Shaded area: outside of estimated noarbitrage band Sources: Bloomberg L.P., and IMF staff estimation. Sources: Bloomberg L.P., and IMF staff estimation. 1/ Represents market view of the most likely direction of the spot movement over the next three months. To confirm that the influence of these variables (Figures 6 and 7) on the basis is robust we estimate a VAR model to test their statistical significance and control for a range of other variables. The dependent variables in the VAR is the onshore-offshore renminbi differential; with the following explanatory variables found to have a statistically significant impact, as reflected in VAR impulse-response functions (see the Annex for technical details);  the change in renminbi liquidity as measured by deposits and CDs in Hong Kong SAR (Figure 6);  the three-month renminbi risk reversal index (Figure 7);  A dummy variable for the opening of new channels for renminbi cross-border flows (see Annex for detailed definitions).  A dummy for when the quota is hit on the size of the aggregate net position that Hong Kong SAR banks can square with the clearing bank at onshore rates for trade-related renminbi payments. The VAR results confirm that the basis is affected by changes in offshore renminbi liquidity. This is the case even when controlling for the endogenity that results from the fact that the arbitrage narrowing the basis also affects offshore liquidity. The results also show that shift 2 The reversal index is defined as the implied volatility for call options minus the implied volatility for put options on the base currency with the same delta. It can be interpreted as the market view of the most likely direction of the spot movement over the next maturity date

in investor sentiment contributes to significant movements in the basis. finally liberalization policy measures also have an independent effect on the basis. Overall, these results suggest that there is considerable scope for policy to affect the arbitrage working to narrow the basis, to enhance onshore-offshore renminbi market integration, and to reduce basis risk. The next section therefore turns to the role of capital account liberalization policy IV. ROLE OF CAPITAL ACCOUNT LIBERALIZATION IN RENMINBI INTERNATIONALIZATION olution of China's Capital Account Liberalization Strategy In recent years, mainland capital account liberalization has been increasingly geared towards supporting renminbi internationalization. This was partly in response to weaknesses in the international monetary system revealed in the 2008-09 global financial crisis. Specifically, the availability of dollars for trade and other cross border financing in global markets temporarily dried up during the crisis, highlighting a risk of relying on a single reserve currency. Another, more recent, consideration is that reliance on the dollar dominated system is the exposure to US unconventional monetary policies that results in global monetary and financial conditions that are excessively lax from China's perspective. This shift in policy focus is clearly evident in liberalization measures announced since 2009(Table 2). These triggered the rapid expansion in renminbi trade settlement and offshore renminbi liquidity (Figures I and 4) Renminbi internationalization and capital account liberalization are seen as a mutually einforcing process by the Chinese authorities(Zhou, 2012). This is part of broad strategy of financial sector reform and development that is aligned with a"gradual and controllable approach to capital account liberalization. However, the goal of promoting wider use of the currency in trade and related international financial transactions is broader in scope tha liberalization in that it also covers nonresidents renminbi-denominated assets and liabilities and off-balance sheet(e.g, forwards and derivatives)activities(He, 2012) Hong Kong Sar has been the primary location in which the offshore renminbi markets developed. It provided a testing ground for the various initiatives to develop the renminbi as an international currency. This reflects, in part, the close co-operation between the mainland process. The launch of offshore renminbi settlement and banking in Hong Kong SAP authorities and Hong Kong Sar that facilitated the monitoring and management of the focused initially on international trade, but the existence of the renminbi platform in Hong Kong SAR facilitated development of other type of renminbi financing and investment activities. HKMA actions have also supported renminbi market by increasing flexibility in regulations designed to limit risks from offshore use of the renminbi as banks demonstrated the capacity to manage these risk more effectively (tables 2 and 3) S A number of variables turned out to be statistically insignificant and, thus, are not reported, notably the difference between the onshore three-month forward rate and the three-month NDF, used as a proxy for expectation of futures changes in the basis

9 in investor sentiment contributes to significant movements in the basis. Finally, liberalization policy measures also have an independent effect on the basis.3 Overall, these results suggest that there is considerable scope for policy to affect the arbitrage working to narrow the basis, to enhance onshore-offshore renminbi market integration, and to reduce basis risk. The next section therefore turns to the role of capital account liberalization policy. IV. ROLE OF CAPITAL ACCOUNT LIBERALIZATION IN RENMINBI INTERNATIONALIZATION A. Evolution of China’s Capital Account Liberalization Strategy In recent years, mainland capital account liberalization has been increasingly geared towards supporting renminbi internationalization. This was partly in response to weaknesses in the international monetary system revealed in the 2008–09 global financial crisis. Specifically, the availability of dollars for trade and other cross border financing in global markets temporarily dried up during the crisis, highlighting a risk of relying on a single reserve currency. Another, more recent, consideration is that reliance on the dollar dominated system is the exposure to US unconventional monetary policies that results in global monetary and financial conditions that are excessively lax from China’s perspective. This shift in policy focus is clearly evident in liberalization measures announced since 2009 (Table 2). These triggered the rapid expansion in renminbi trade settlement and offshore renminbi liquidity (Figures 1 and 4). Renminbi internationalization and capital account liberalization are seen as a mutuallyreinforcing process by the Chinese authorities (Zhou, 2012). This is part of broad strategy of financial sector reform and development that is aligned with a “gradual and controllable” approach to capital account liberalization. However, the goal of promoting wider use of the currency in trade and related international financial transactions is broader in scope than liberalization in that it also covers nonresidents’ renminbi-denominated assets and liabilities, and off-balance sheet (e.g., forwards and derivatives) activities (He, 2012). Hong Kong SAR has been the primary location in which the offshore renminbi markets developed. It provided a testing ground for the various initiatives to develop the renminbi as an international currency. This reflects, in part, the close co-operation between the mainland authorities and Hong Kong SAR that facilitated the monitoring and management of the process. The launch of offshore renminbi settlement and banking in Hong Kong SAR focused initially on international trade, but the existence of the renminbi platform in Hong Kong SAR facilitated development of other type of renminbi financing and investment activities. HKMA actions have also supported renminbi market by increasing flexibility in regulations designed to limit risks from offshore use of the renminbi as banks demonstrated the capacity to manage these risk more effectively (Tables 2 and 3). 3 A number of variables turned out to be statistically insignificant and, thus, are not reported, notably the difference between the onshore three-month forward rate and the three-month NDF, used as a proxy for expectation of futures changes in the basis

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